What Is A 10/1 ARM And How Does It Work?

What Is A 10/1 ARM And How Does It Work?

A 10/1 ARM is an adjustable rate mortgage loan with a fixed rate for the first 10 years. After that, it has an adjustable rate that usually changes once each year for the remaining life of the loan. There is a cap on the rate adjustment per year and a limit to how much the rate can go up total. The loan usually amortizes over a total of 30 years.

ARM stands for Adjustable Rate Mortgage as opposed to a 30-year fixed rate mortgage. Since interest rates have been steadily coming down since the late 1980s, ARMs have become more and more popular over time compared to 30-year fixed rate mortgages that have higher interest rates.

If the interest rate goes up after 10 years, the borrower's payment could go up. But not necessarily since during this 10 year period, the borrower has been steadily paying down principal. But if the interest rate goes down after 10 years, the borrowers payment will most certainly go down.

Homebuyers who take out a 10/1 ARM are essentially taking a view on the future of interest rates.

The Definition Of A 10/1 ARM

Taking out an ARM allows homebuyers to afford more home. But taking out an ARM is also a way for homebuyers to save on mortgage interest for the life of their homeownership.

Given the average homeowner owns his or her home for nine years, taking out a 10/1 ARM is one of the smartest types of mortgages to get. Taking out a 30-year fixed mortgage basically costs the average homeowner a lot more money than necessary.

You always want to MATCH your fixed rate mortgage portion to the duration you plan to own your home or pay it off.

The change in interest rate once the fixed rate period is over is tied to an index that determines how much your interest rate will rise or fall at each adjustment period.

An index is a published interest rate based on the returns of investments such as U.S. Treasury securities. One common index is the LIBOR index. The LIBOR index also has shorter term and longer term durations as well. It's up to the bank to choose which index it wants to use to price your loan.

Fed Funds Rate Chart

With a 10/1 ARM, the interest rate does not begin changing based on the index immediately. Instead, the interest rate on a 10 year ARM is fixed for the first 10 years of the loan.

After 10 years, the interest rate can change annually for the next 25 years until the loan is paid off.

The first number in the name 10/1 ARM indicates the number of years of the fixed period while the second number indicates the adjustment interval. An adjustment interval is the period between potential rate changes (in this case, one year).

Pros and Cons Of An ARM

With a 10/1 ARM, you know exactly what your interest rate will be for the first 10 years. After that, your interest rate, and therefore your monthly payment, could go up or down.

We've been in a declining or low interest rate environment for over 40 years. Rates started to go up in 2022, but notice how much lower they still are compared to the 80s and 90s. Chances are still good that your payment won't go up too much once the 10-year fixed period is up.

Latest mortgage rates 2022

Not only may interest rates be similar 10 years from now, your principal balance will have absolutely declined by at least 10%.

With a lower principal balance to pay off upon interest rate adjustment, even if interest rates increased a lot, it would be offset by the lower balance.

10/1 ARM Example

Let’s say you are purchasing a $500,000 house and putting down 20 percent. You could borrow $400,000 at a 4.5 percent interest rate at a monthly payment of $2,027.

Alternatively, you could take out a 10/1 ARM for the $400,000 loan and borrow at a 3.5 percent interest rate. Your payment would go down to $1,796 a month, thereby improving your cash flow by $231 a month.

After 10 years when it's time for your ARM to adjust, your principal amount will decline to roughly $360,000. Even if your mortgage rate adjusts to 4 percent from 3.5 percent, you're still paying roughly the same amount in monthly mortgage payments.

Meanwhile, if you had taken out a 30-year fixed loan at 4.5%, you'd be losing compared to the ARM holder even on year six when the ARM holder's rate adjusts.

Finally, you can always refinance your ARM before the fixed rate period is up, and recast the loan based on a 30 year amortizing term to help reduce your mortgage payments.

Who Should Get An ARM?

I'm a big believer in an adjustable rate mortgage over a 30-year fixed rate mortgage. We are in a permanently lower interest rate environment thanks to technological efficiency, policy efficiency, and greater knowledge of economic cycles.

Further, given the average homeowner lives in their house for nine years, there's no need to get an ARM longer than a 10/1. Longer fixed duration loans cost more money because the yield curve is generally upward sloping.

Finally, it is not recommended to spend 30 years to pay off your house. If you do, you'll end up paying an enormous amount of interest on your home. Try to pay off your house within 15 years. You'll save money and feel great knowing you are mortgage debt free.

Shop around for a lower mortgage rate: Check the latest mortgage rates online. You'll get real quotes from pre-vetted, qualified lenders in under three minutes. The more free mortgage rate quotes you can get, the better. This way, you feel confident knowing you're getting the lowest rate for your situation. Further, you can make lenders compete for your business. 

As a multi-property homeowner since 2003, I truly believe a 10/1 ARM is one of the best types of mortgages to get. Take advantage of low mortgage rates!

About the Author: Sam worked in investing banking for 13 years at GS and CS. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income, most recently helped by real estate crowdfunding. He spends most of his time playing tennis and taking care of his family. Financial Samurai was started in 2009 and is one of the most trusted personal finance sites on the web with over 1.5 million pageviews a month.